CHAPTER 3 The Accounting Information System

ACCOUNTING INFORMATION SYSTEM

An accounting information system collects and processes transaction data and then disseminates the financial information to interested parties. Accounting information systems vary widely from one business to another. Various factors shape these systems: the nature of the business and the transactions in which it engages, the size of the firm, the volume of data to be handled, and the informational demands that management and others require.

As we discussed in Chapters 1 and 2, in response to the requirements of the Sarbanes-Oxley Act, companies are placing a renewed focus on their accounting systems to ensure relevant and reliable information is reported in financial statements.¹ A good accounting information system helps management answer such questions as:

• How much and what kind of debt is outstanding?
• Were our sales higher this period than last?
• What assets do we have?
• What were our cash inflows and outflows?
• Did we make a profit last period?
• Are any of our product lines or divisions operating at a loss?
• Can we safely increase our dividends to stockholders?
• Is our rate of return on net assets increasing?

Management can answer many other questions with the data provided by an efficient accounting system. A well-devised accounting information system benefits every type of company.

Basic Terminology

Financial accounting rests on a set of concepts (discussed in Chapters 1 and 2) for identifying, recording, classifying, and interpreting transactions and other events relating to enterprises. You therefore need to understand the basic terminology employed in collecting accounting data.

Debits and Credits

The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These terms do not mean increase or decrease, but instead describe where a company makes entries in the recording process. That is, when a company enters an amount on the left side of an account, it debits the account. When it makes an entry on the right side, it credits the account. When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.

The positioning of debits on the left and credits on the right is simply an accounting custom. We could function just as well if we reversed the sides. However, the United States adopted the custom, now the rule, of having debits on the left side of an account and credits on the right side, similar to the custom of driving on the right-hand side of the road. This rule applies to all accounts.

The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-entry accounting system, a company records the dual (two-sided) effect of each transaction in appropriate accounts. This system provides a logical method for recording transactions. It also offers a means of proving the accuracy of the recorded amounts. If a company records every transaction with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits.

Illustration 3-1 presents the basic guidelines for an accounting system. Increases to all asset and expense accounts occur on the left (or debit side) and decreases on the right (or credit side). Conversely, increases to all liability and revenue accounts occur on the right (or credit side) and decreases on the left (or debit side). A company increases stockholders' equity accounts, such as Common Stock and Retained Earnings, on the credit side, but increases Dividends on the debit side.

The Accounting Equation

In a double-entry system, for every debit there must be a credit, and vice versa. This leads us, then, to the basic equation in accounting (Illustration 3-2).

Illustration 3-3 expands this equation to show the accounts that make up stockholders' equity. The figure also shows the debit/credit rules and effects on each type of account. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system. Like the basic equation, the expanded equation must also balance (total debits equal total credits).

Every time a transaction occurs, the elements of the accounting equation change. However, the basic equality remains. To illustrate, consider the following eight different transactions for Perez Inc.

1. Owners invest $40,000 in exchange for common stock.

   

2. Disburse $600 cash for secretarial wages.

   

3. Purchase office equipment priced at $5,200, giving a 10 percent promissory note in exchange.

   

4. Receive $4,000 cash for services performed.

   

5. Pay off a short-term liability of $7,000.

   

6. Declare a cash dividend of $5,000.

   

7. Convert a long-term liability of $80,000 into common stock.

   

8. Pay cash of $16,000 for a delivery van.

   

Financial Statements and Ownership Structure

The stockholders' equity section of the balance sheet reports common stock and retained earnings. The income statement reports revenues and expenses. The statement of retained earnings reports dividends. Because a company transfers dividends, revenues, and expenses to retained earnings at the end of the period, a change in any one of these three items affects stockholders' equity. Illustration 3-4 shows the stockholders' equity relationships.

The company's ownership structure dictates the types of accounts that are part of or affect the equity section. A corporation commonly uses Common Stock, Paid-in Capital in Excess of Par, Dividends, and Retained Earnings accounts. A proprietorship or a partnership uses an Owner's Capital account and an Owner's Drawings account. An Owner's Capital account indicates the owner's or owners' investment in the company. An Owner's Drawings account tracks withdrawals by the owner(s).

Illustration 3-5 summarizes and relates the transactions affecting owners' equity to the nominal (temporary) and real (permanent) classifications and to the types of business ownership.

THE ACCOUNTING CYCLE

Illustration 3-6 (on page 90) shows the steps in the accounting cycle. A company normally uses these accounting procedures to record transactions and prepare financial statements.

Identifying and Recording Transactions and Other Events

The first step in the accounting cycle is analysis of transactions and selected other events. The first problem is to determine what to record. Although GAAP provides guidelines, no simple rules exist that state which events a company should record. Although changes in a company's personnel or managerial policies may be important, the company should not record these items in the accounts. On the other hand, a company should record all cash sales or purchases—no matter how small.

The concepts we presented in Chapter 2 determine what to recognize in the accounts. An item should be recognized in the financial statements if it is an element, is measurable, and is relevant and representationally faithful. Consider human resources. R. G. Barry & Co. at one time reported as supplemental data total assets of $14,055,926, including $986,094 for “Net investments in human resources.” AT&T and ExxonMobil also experimented with human resource accounting. Should we value employees for balance sheet and income statement purposes? Certainly skilled employees are an important asset (highly relevant), but the problems of determining their value and measuring it reliably have not yet been solved. Consequently, human resources are not recorded. Perhaps when measurement techniques become more sophisticated and accepted, such information will be presented, if only in supplemental form.

The FASB uses the phrase “transactions and other events and circumstances that affect a business enterprise” to describe the sources or causes of changes in an entity's assets, liabilities, and equity.² Events are of two types. (1) External events involve interaction between an entity and its environment, such as a transaction with another entity, a change in the price of a good or service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a competitor. (2) Internal events occur within an entity, such as using buildings and machinery in operations, or transferring or consuming raw materials in production processes.

Many events have both external and internal elements. For example, hiring an employee, which involves an exchange of salary for labor, is an external event. Using the services of labor is part of production, an internal event. Further, an entity may initiate and control events, such as the purchase of merchandise or use of a machine. Or, events may be beyond its control, such as an interest rate change, theft, or a tax hike.

Transactions are types of external events. They may be an exchange between two entities where each receives and sacrifices value, such as purchases and sales of goods or services. Or, transactions may be transfers in one direction only. For example, an entity may incur a liability without directly receiving value in exchange, such as charitable contributions. Other examples include investments by owners, distributions to owners, payment of taxes, gifts, casualty losses, and thefts.

In short, a company records as many events as possible that affect its financial position. As discussed earlier in the case of human resources, it omits some events because of tradition and others because of complicated measurement problems. Recently, however, the accounting profession shows more receptiveness to accepting the challenge of measuring and reporting events previously viewed as too complex and immeasurable.

Journalizing

A company records in accounts those transactions and events that affect its assets, liabilities, and equities. The general ledger contains all the asset, liability, and stockholders' equity accounts. An account (see Illustration 3-3, on page 87) shows the effect of transactions on particular asset, liability, equity, revenue, and expense accounts.

In practice, companies do not record transactions and selected other events originally in the ledger. A transaction affects two or more accounts, each of which is on a different page in the ledger. Therefore, in order to have a complete record of each transaction or other event in one place, a company uses a journal (also called “the book of original entry”). In its simplest form, a general journal chronologically lists transactions and other events, expressed in terms of debits and credits to accounts.

Illustration 3-7 shows the technique of journalizing, using the first two transactions for Softbyte, Inc. These transactions were:

September 1

Stockholders invested $15,000 cash in the corporation in exchange for shares of stock. Purchased computer equipment for $7,000 cash.

The J1 indicates these two entries are on the first page of the general journal.

Each general journal entry consists of four parts: (1) the accounts and amounts to be debited (Dr.), (2) the accounts and amounts to be credited (Cr.), (3) a date, and (4) an explanation. A company enters debits first, followed by the credits (slightly indented). The explanation begins below the name of the last account to be credited and may take one or more lines. A company completes the “Ref.” column at the time it posts the accounts.

In some cases, a company uses special journals in addition to the general journal. Special journals summarize transactions possessing a common characteristic (e.g., cash receipts, sales, purchases, cash payments). As a result, using them reduces bookkeeping time.

Posting

Transferring journal entries to the ledger accounts is called posting. Posting involves the following steps.

1. In the ledger, in the appropriate columns of the account(s) debited, enter the date, journal page, and debit amount shown in the journal.
2. In the reference column of the journal, write the account number to which the debit amount was posted.
3. In the ledger, in the appropriate columns of the account(s) credited, enter the date, journal page, and credit amount shown in the journal.
4. In the reference column of the journal, write the account number to which the credit amount was posted.

Illustration 3-8 diagrams these four steps, using the first journal entry of Softbyte, Inc. The illustration shows the general ledger accounts in standard account form. Some companies call this form the three-column form of account because it has three money columns—debit, credit, and balance. The balance in the account is determined after each transaction. The explanation space and reference columns provide special information about the transaction. The boxed numbers indicate the sequence of the steps.

The numbers in the “Ref.” column of the general journal refer to the ledger accounts to which a company posts the respective items. For example, the “101” placed in the column to the right of “Cash” indicates that the company posted this $15,000 item to Account No. 101 in the ledger.

The posting of the general journal is completed when a company records all of the posting reference numbers opposite the account titles in the journal. Thus, the number in the posting reference column serves two purposes. (1) It indicates the ledger account number of the account involved. (2) It indicates the completion of posting for the particular item. Each company selects its own numbering system for its ledger accounts. Many begin numbering with asset accounts and then follow with liabilities, owners' equity, revenue, and expense accounts, in that order.

The ledger accounts in Illustration 3-8 show the accounts after completion of the posting process. The reference J1 (General Journal, page 1) indicates the source of the data transferred to the ledger account.

An Expanded Example

To show an expanded example of the basic steps in the recording process, we use the October transactions of Pioneer Advertising Agency Inc. Pioneer's accounting period is a month. Illustrations 3-9 through 3-18 show the journal entry and posting of each transaction. For simplicity, we use a T-account form instead of the standard account form. Study the transaction analyses carefully.

The purpose of transaction analysis is (1) to identify the type of account involved, and (2) to determine whether a debit or a credit is required. You should always perform this type of analysis before preparing a journal entry. Doing so will help you understand the journal entries discussed in this chapter as well as more complex journal entries in later chapters. Keep in mind that every journal entry affects one or more of the following items: assets, liabilities, stockholders' equity, revenues, or expenses.

1. October 1: Stockholders invest $100,000 cash in an advertising venture to be known as Pioneer Advertising Agency Inc.

   ILLUSTRATION 3-9 Investment of Cash by Stockholders

   

2. October 1: Pioneer Advertising purchases office equipment costing $50,000 by signing a 3-month, 12%, $50,000 note payable.

   ILLUSTRATION 3-10 Purchase of Office Equipment

   

3. October 2: Pioneer Advertising receives a $12,000 cash advance from R. Knox, a client, for advertising services that are expected to be completed by December 31.

   ILLUSTRATION 3-11 Receipt of Cash for Future Service

   

4. October 3: Pioneer Advertising pays $9,000 office rent, in cash, for October.

   ILLUSTRATION 3-12 Payment of Monthly Rent

   

5. October 4: Pioneer Advertising pays $6,000 for a one-year insurance policy that will expire next year on September 30.

   ILLUSTRATION 3-13 Payment for Insurance

   

6. October 5: Pioneer Advertising purchases, for $25,000 on account, an estimated 3-month supply of advertising materials from Aero Supply.

   ILLUSTRATION 3-14 Purchase of Supplies on Account

   

7. October 9: Pioneer Advertising signs a contract with a local newspaper for advertising inserts (flyers) to be distributed starting the last Sunday in November. Pioneer will start work on the content of the flyers in November. Payment of $7,000 is due following delivery of the Sunday papers containing the flyers.

   ILLUSTRATION 3-15 Signing a Contract

   

8. October 20: Pioneer Advertising's board of directors declares and pays a $5,000 cash dividend to stockholders.

   ILLUSTRATION 3-16 Declaration and Payment of Dividend by Corporation

   

9. October 26: Pioneer Advertising pays employee salaries and wages in cash. Employees are paid once a month, every four weeks. The total payroll is $10,000 per week, or $2,000 per day. In October, the pay period began on Monday, October 1. As a result, the pay period ended on Friday, October 26, with salaries and wages of $40,000 being paid.

   ILLUSTRATION 3-17 Payment of Salaries and Wages

   

10. October 31: Pioneer Advertising receives $28,000 in cash and bills Copa Company $72,000 for advertising services of $100,000 performed in October.

    ILLUSTRATION 3-18 Recognize Revenue for Services Performed

    

Trial Balance

A trial balance is a list of accounts and their balances at a given time. A company usually prepares a trial balance at the end of an accounting period. The trial balance lists the accounts in the order in which they appear in the ledger, with debit balances listed in the left column and credit balances in the right column. The totals of the two columns must agree.

The trial balance proves the mathematical equality of debits and credits after posting. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance also uncovers errors in journalizing and posting. In addition, it is useful in the preparation of financial statements. The procedures for preparing a trial balance consist of:

1. List the account titles and their balances in the appropriate debit or credit column.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.

Illustration 3-19 presents the trial balance prepared from the ledger of Pioneer Advertising Agency Inc. Note that the total debits ($287,000) equal the total credits ($287,000). A trial balance also often shows account numbers to the left of the account titles.

A trial balance does not prove that a company recorded all transactions or that the ledger is correct. Numerous errors may exist even though the trial balance columns agree. For example, the trial balance may balance even when a company (1) fails to journalize a transaction, (2) omits posting a correct journal entry, (3) posts a journal entry twice, (4) uses incorrect accounts in journalizing or posting, or (5) makes offsetting errors in recording the amount of a transaction. In other words, as long as a company posts equal debits and credits, even to the wrong account or in the wrong amount, the total debits will equal the total credits.

Adjusting Entries

In order for revenues to be recorded in the period in which services are performed and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. In short, adjustments ensure that a company like McDonald's follows the revenue recognition and expense recognition principles.

The use of adjusting entries makes it possible to report on the balance sheet the appropriate assets, liabilities, and owners' equity at the statement date. Adjusting entries also make it possible to report on the income statement the proper revenues and expenses for the period. However, the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This occurs for the following reasons.

1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees.
2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples of such costs are building and equipment depreciation and rent and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.

Adjusting entries are required every time a company, such as Coca-Cola, prepares financial statements. At that time, Coca-Cola must analyze each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. The analysis requires a thorough understanding of Coca-Cola's operations and the interrelationship of accounts. Because of this involved process, usually a skilled accountant prepares the adjusting entries. In gathering the adjustment data, Coca-Cola may need to make inventory counts of supplies and repair parts. Further, it may prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Companies often prepare adjustments after the balance sheet date. However, they date the entries as of the balance sheet date.

Types of Adjusting Entries

Adjusting entries are classified as either deferrals or accruals. Each of these classes has two subcategories, as Illustration 3-20 shows.

We review specific examples and explanations of each type of adjustment in subsequent sections. We base each example on the October 31 trial balance of Pioneer Advertising Agency Inc. (Illustration 3-19). We assume that Pioneer uses an accounting period of one month. Thus, Pioneer will make monthly adjusting entries, dated October 31.

Adjusting Entries for Deferrals

To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues.

If a company does not make an adjustment for these deferrals, the asset and liability are overstated, and the related expense and revenue are understated. For example, in Pioneer's trial balance (Illustration 3-19), the balance in the asset Supplies shows only supplies purchased. This balance is overstated; the related expense account, Supplies Expense, is understated because the cost of supplies used has not been recognized. Thus, the adjusting entry for deferrals will decrease a balance sheet account and increase an income statement account. Illustration 3-21 shows the effects of adjusting entries for deferrals.

Prepaid Expenses. Assets paid for and recorded before a company uses them are called prepaid expenses. When expenses are prepaid, a company debits an asset account to show the service or benefit it will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use and consumption (e.g., supplies). The expiration of these costs does not require daily entries, an unnecessary and impractical task. Accordingly, a company like Walgreens usually postpones the recognition of such cost expirations until it prepares financial statements. At each statement date, Walgreens makes adjusting entries to record the expenses that apply to the current accounting period and to show the remaining amounts in the asset accounts.

As shown above, prior to adjustment, assets are overstated and expenses are understated. Thus, an adjusting entry for prepaid expenses results in a debit to an expense account and a credit to an asset account.

Supplies. A business may use several different types of supplies. For example, a CPA firm will use office supplies such as stationery, envelopes, and accounting paper. An advertising firm will stock advertising supplies such as graph paper, video film, and poster paper. Supplies are generally debited to an asset account when they are acquired. Recognition of supplies used is generally deferred until the adjustment process. At that time, a physical inventory (count) of supplies is taken. The difference between the balance in the Supplies (asset) account and the cost of supplies on hand represents the supplies used (an expense) for the period.

For example, Pioneer Advertising purchased advertising supplies costing $25,000 on October 5. Pioneer therefore debited the asset Supplies. This account shows a balance of $25,000 in the October 31 trial balance (see Illustration 3-19 on page 96). An inventory count at the close of business on October 31 reveals that $10,000 of supplies are still on hand. Thus, the cost of supplies used is $15,000 ($25,000 − $10,000). The analysis and adjustment for advertising supplies is summarized in Illustration 3-22.

After adjustment, the asset account Supplies shows a balance of $10,000, which equals the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of $15,000, which equals the cost of supplies used in October. Without an adjusting entry, October expenses are understated and net income overstated by $15,000. Moreover, both assets and stockholders' equity are overstated by $15,000 on the October 31 balance sheet.

Insurance. Most companies maintain fire and theft insurance on merchandise and equipment, personal liability insurance for accidents suffered by customers, and automobile insurance on company cars and trucks. The extent of protection against loss determines the cost of the insurance (the amount of the premium to be paid). The insurance policy specifies the term and coverage. The minimum term usually covers one year, but three-to five-year terms are available and may offer lower annual premiums. A company usually debits insurance premiums to the asset account Prepaid Insurance when paid. At the financial statement date, it then debits Insurance Expense and credits Prepaid Insurance for the cost that expired during the period.

For example, on October 4, Pioneer Advertising paid $6,000 for a one-year fire insurance policy. Coverage began on October 1. Pioneer debited the cost of the premium to Prepaid Insurance at that time. This account still shows a balance of $6,000 in the October 31 trial balance. The analysis and adjustment for insurance is summarized in Illustration 3-23 (page 100).

The asset Prepaid Insurance shows a balance of $5,500, which represents the unexpired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. Without an adjusting entry, October expenses are understated by $500 and net income overstated by $500. Moreover, both assets and stockholders' equity also are overstated by $500 on the October 31 balance sheet.

Depreciation. Companies like Caterpillar or Boeing typically own various productive facilities, such as buildings, equipment, and motor vehicles. These assets provide a service for a number of years. The term of service is commonly referred to as the useful life of the asset. Because Caterpillar, for example, expects an asset such as a building to provide service for many years, Caterpillar records the building as an asset, rather than an expense, in the year the building is acquired. Caterpillar records such assets at cost, as required by the historical cost principle.

To follow the expense recognition principle, Caterpillar reports a portion of the cost of a long-lived asset as an expense during each period of the asset's useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.

Need for depreciation adjustment. Generally accepted accounting principles (GAAP) view the acquisition of productive facilities as a long-term prepayment for services. The need for making periodic adjusting entries for depreciation is, therefore, the same as we described for other prepaid expenses. That is, a company recognizes the expired cost (expense) during the period and reports the unexpired cost (asset) at the end of the period. The primary causes of depreciation of a productive facility are actual use, deterioration due to the elements, and obsolescence. For example, at the time Caterpillar acquires an asset, the effects of these factors cannot be known with certainty. Therefore, Caterpillar must estimate them. Thus, depreciation is an estimate rather than a factual measurement of the expired cost.

To estimate depreciation expense, Caterpillar often divides the cost of the asset by its useful life. For example, if Caterpillar purchases equipment for $10,000 and expects its useful life to be 10 years, Caterpillar records annual depreciation of $1,000.

In the case of Pioneer Advertising, it estimates depreciation on its office equipment to be $4,800 a year (cost $50,000 less salvage value $2,000 divided by useful life of 10 years), or $400 per month. The analysis and adjustment for depreciation is summarized in Illustration 3-24.

The balance in the Accumulated Depreciation—Equipment account will increase $400 each month. Therefore, after recording and posting the adjusting entry at November 30, the balance will be $800.

Statement presentation. Accumulated Depreciation—Equipment is a contra asset account. A contra asset account offsets an asset account on the balance sheet. This means that the Accumulated Depreciation—Equipment account offsets the Equipment account on the balance sheet. Its normal balance is a credit. Pioneer uses this account instead of crediting Equipment in order to disclose both the original cost of the equipment and the total expired cost to date. In the balance sheet, Pioneer deducts Accumulated Depreciation—Equipment from the related asset account as follows.

The book value of any depreciable asset is the difference between its cost and its related accumulated depreciation. In Illustration 3-25, the book value of the equipment at the balance sheet date is $49,600. Note that the asset's book value generally differs from its fair value. The reason: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset's cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

Depreciation expense identifies that portion of the asset's cost that expired during the period (in this case, October). Without this adjusting entry, total assets, total stockholders' equity, and net income are overstated, and depreciation expense is understated.

A company records depreciation expense for each piece of equipment, such as trucks or machinery, and for all buildings. A company also establishes related accumulated depreciation accounts for the above, such as Accumulated Depreciation—Trucks, Accumulated Depreciation—Machinery, and Accumulated Depreciation—Buildings.

Unearned Revenues. When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues. In other words, a company now has a performance obligation (liability) to provide service to one its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines, such as Delta, American, and Southwest, treat receipts from the sale of tickets as unearned revenue until they provide the flight service. Tuition received prior to the start of a semester is another example of unearned revenue.

Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepayment on the books of the company that made the advance payment. For example, if we assume identical accounting periods, a landlord will have unearned rent revenue when a tenant has prepaid rent.

When a company such as Intel receives payment for services to be performed in a future accounting period, it credits an unearned revenue (a liability) account to recognize the liability that exists. Intel subsequently recognizes revenue when it performs the service. However, making daily entries to record this revenue is impractical. Instead, Intel delays recognition of revenue until the adjustment process. Then, Intel makes an adjusting entry to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period. In the typical case, liabilities are overstated and revenues are understated prior to adjustment. Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a liability account and a credit (increase) to a revenue account.

For example, Pioneer Advertising received $12,000 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $12,000 in the October 31 trial balance. Based on an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize $4,000 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased and stockholders' equity (Service Revenue) is increased, as shown in Illustration 3-26.

The liability Unearned Service Revenue now shows a balance of $8,000. This amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of $104,000. Without this adjustment, revenues and net income are understated by $4,000 in the income statement. Moreover, liabilities will be overstated and stockholders' equity will be understated by $4,000 on the October 31 balance sheet.

Adjusting Entries for Accruals

The second category of adjusting entries is accruals. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the current accounting period. Without an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account. Illustration 3-27 shows adjusting entries for accruals.

Accrued Revenues. Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients will not be billed until the service has been completed.

An adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. Accordingly, an adjusting entry for accrued revenues results in a debit (increase) to an asset account and a credit (increase) to a revenue account.

In October, Pioneer Advertising performed services worth $2,000 that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases stockholders' equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-28.

The asset Accounts Receivable shows that clients owe $74,000 at the balance sheet date. The balance of $106,000 in Service Revenue represents the total revenue for services performed by Pioneer during the month ($100,000 + $4,000 + $2,000). Without an adjusting entry, assets and stockholders' equity on the balance sheet, and revenues and net income on the income statement, are understated.

Accrued Expenses. Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, rent, taxes, and salaries are common examples. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. For example, the $2,000 accrual of service revenue by Pioneer is an accrued expense to the client that received the service.

Adjustments for accrued expenses record the obligations that exist at the balance sheet date and recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a liability account.

Accrued interest. Pioneer Advertising signed a three-month note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. For Pioneer, the total interest due on the $50,000 note at its maturity date three months' in the future is $1,500 ($50,000 × 12% × 3/12), or $500 for one month. Illustration 3-29 shows the formula for computing interest and its application to Pioneer. Note that the formula expresses the time period as a fraction of a year.

As Illustration 3-30 shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases stockholders' equity by increasing an expense account, Interest Expense.

Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest owed at the statement date. Pioneer will not pay this amount until the note comes due at the end of three months. Why does Pioneer use the Interest Payable account instead of crediting Notes Payable? By recording interest payable separately, Pioneer discloses the two different types of obligations—interest and principal—in the accounts and statements. Without this adjusting entry, liabilities and interest expense are understated, and both net income and stockholders' equity are overstated.

Accrued salaries and wages. Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. For example, Pioneer Advertising last paid salaries and wages on October 26. It will not pay salaries and wages again until November 23. However, as shown in the calendar below, three working days remain in October (October 29–31).

At October 31, the salaries and wages for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of $10,000 for a five-day work week, or $2,000 per day. Thus, accrued salaries and wages at October 31 are $6,000 ($2,000 × 3). The analysis and adjustment process is summarized in Illustration 3-31.

After this adjustment, the balance in Salaries and Wages Expense of $46,000 (23 days × $2,000) is the actual salaries and wages expense for October. The balance in Salaries and Wages Payable of $6,000 is the amount of the liability for salaries and wages owed as of October 31. Without the $6,000 adjustment for salaries, both Pioneer's expenses and liabilities are understated by $6,000.

Pioneer pays salaries and wages every four weeks. Consequently, the next payday is November 23, when it will again pay total salaries and wages of $40,000. The payment consists of $6,000 of salaries and wages payable at October 31 plus $34,000 of salaries and wages expense for November (17 working days as shown in the November calendar × $2,000). Therefore, Pioneer makes the following entry on November 23.

This entry eliminates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry. This entry also records the proper amount of Salaries and Wages Expense for the period between November 1 and November 23.

Bad debts. Proper recognition of revenues and expenses dictates recording bad debts as an expense of the period in which a company recognizes revenue for services performed instead of the period in which the company writes off the accounts or notes. The proper valuation of the receivable balance also requires recognition of uncollectible receivables. Proper recognition and valuation require an adjusting entry.

At the end of each period, a company such as General Mills estimates the amount of receivables that will later prove to be uncollectible. General Mills bases the estimate on various factors: the amount of bad debts it experienced in past years, general economic conditions, how long the receivables are past due, and other factors that indicate the extent of uncollectibility. To illustrate, assume that, based on past experience, Pioneer Advertising reasonably estimates a bad debt expense for the month of $1,600. The analysis and adjustment process for bad debts is summarized in Illustration 3-32 (page 108).

A company often expresses bad debts as a percentage of the revenue on account for the period. Or, a company may compute bad debts by adjusting Allowance for Doubtful Accounts to a certain percentage of the trade accounts receivable and trade notes receivable at the end of the period.

Adjusted Trial Balance

After journalizing and posting all adjusting entries, Pioneer Advertising prepares another trial balance from its ledger accounts (shown in Illustration 3-33 on page 109). This trial balance is called an adjusted trial balance. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.

Preparing Financial Statements

As indicated above, Pioneer Advertising can prepare financial statements directly from the adjusted trial balance. Illustrations 3-34 (page 109) and 3-35 (page 110) show the interrelationships of data in the adjusted trial balance and the financial statements.

As Illustration 3-34 shows, Pioneer prepares the income statement from the revenue and expense accounts. Next, it derives the retained earnings statement from the retained earnings and dividends accounts and the net income (or net loss) shown in the income statement.

As Illustration 3-35 shows, Pioneer then prepares the balance sheet from the asset and liability accounts, the common stock account, and the ending retained earnings balance as reported in the retained earnings statement.

Closing

Basic Process

The closing process reduces the balance of nominal (temporary) accounts to zero in order to prepare the accounts for the next period's transactions. In the closing process, Pioneer Advertising transfers all of the revenue and expense account balances (income statement items) to a clearing or suspense account called Income Summary. The Income Summary account matches revenues and expenses.

Pioneer uses this clearing account only at the end of each accounting period. The account represents the net income or net loss for the period. It then transfers this amount (the net income or net loss) to an owners' equity account. (For a corporation, the owners' equity account is retained earnings; for proprietorships and partnerships, it is a capital account.) Companies post all such closing entries to the appropriate general ledger accounts.

Closing Entries

In practice, companies generally prepare closing entries only at the end of a company's annual accounting period. However, to illustrate the journalizing and posting of closing entries, we will assume that Pioneer Advertising closes its books monthly. Illustration 3-36 shows the closing entries at October 31.

A couple of cautions about preparing closing entries. (1) Avoid unintentionally doubling the revenue and expense balances rather than zeroing them. (2) Do not close Dividends through the Income Summary account. Dividends are not expenses, and they are not a factor in determining net income.

Posting Closing Entries

Illustration 3-37 (page 112) shows the posting of closing entries and the underlining (ruling) of accounts. All temporary accounts have zero balances after posting the closing entries. In addition, note that the balance in Retained Earnings represents the accumulated undistributed earnings of Pioneer at the end of the accounting period. Pioneer reports this amount in the balance sheet as the ending amount reported on the retained earnings statement. As noted above, Pioneer uses the Income Summary account only in closing. It does not journalize and post entries to this account during the year.

As part of the closing process, Pioneer totals, balances, and double-underlines the temporary accounts—revenues, expenses, and dividends—as shown in T-account form in Illustration 3-37. It does not close the permanent accounts—assets, liabilities, and stockholders' equity (Common Stock and Retained Earnings). Instead, Pioneer draws a single underline beneath the current period entries for the permanent accounts. The account balance is then entered below the single underline and is carried forward to the next period (see, for example, Retained Earnings).

After the closing process, each income statement account and the dividend account are balanced out to zero and are ready for use in the next accounting period.

Post-Closing Trial Balance

Recall that a trial balance is prepared after entering the regular transactions of the period, and that a second trial balance (the adjusted trial balance) occurs after posting the adjusting entries. A company may take a third trial balance after posting the closing entries. The trial balance after closing is called the post-closing trial balance. The purpose of the post-closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent (real)—balance sheet—accounts.

Illustration 3-38 shows the post-closing trial balance of Pioneer Advertising Agency Inc.

A post-closing trial balance provides evidence that the company has properly journalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period. However, like the other trial balances, it does not prove that Pioneer has recorded all transactions or that the ledger is correct. For example, the post-closing trial balance will balance if a transaction is not journalized and posted, or if a transaction is journalized and posted twice.

Reversing Entries—An Optional Step

Some accountants prefer to reverse the effects of certain adjusting entries by making a reversing entry at the beginning of the next accounting period. A reversing entry is the exact opposite of the adjusting entry made in the previous period. Use of reversing entries is an optional bookkeeping procedure; it is not a required step in the accounting cycle. Accordingly, we have chosen to cover this topic in Appendix 3B at the end of the chapter.

The Accounting Cycle Summarized

A summary of the steps in the accounting cycle shows a logical sequence of the accounting procedures used during a fiscal period:

1. Enter the transactions of the period in appropriate journals.
2. Post from the journals to the ledger (or ledgers).
3. Take an unadjusted trial balance (trial balance).
4. Prepare adjusting journal entries and post to the ledger(s).
5. Take a trial balance after adjusting (adjusted trial balance).
6. Prepare the financial statements from the second trial balance.
7. Prepare closing journal entries and post to the ledger(s).
8. Take a post-closing trial balance (optional).
9. Prepare reversing entries (optional) and post to the ledger(s).

A company normally completes all of these steps in every fiscal period.

FINANCIAL STATEMENTS FOR A MERCHANDISING COMPANY

Pioneer Advertising Agency Inc. is a service company. In this section, we show a detailed set of financial statements for a merchandising company, Uptown Cabinet Corp. The financial statements (see pages 115–116) are prepared from the adjusted trial balance.

Income Statement

The income statement for Uptown, shown in Illustration 3-39, is self-explanatory. The income statement classifies amounts into such categories as gross profit on sales, income from operations, income before taxes, and net income. Although earnings per share information is required to be shown on the face of the income statement for a corporation, we omit this item here as it will be discussed more fully later in the textbook. For homework problems, do not present earnings per share information unless required to do so.

Statement of Retained Earnings

A corporation may retain the net income earned in the business, or it may distribute it to stockholders by payment of dividends. In Illustration 3-40, Uptown added the net income earned during the year to the balance of retained earnings on January 1, thereby increasing the balance of retained earnings. Deducting dividends of $2,000 results in the ending retained earnings balance of $26,400 on December 31.

Balance Sheet

The balance sheet for Uptown, shown in Illustration 3-41 (page 116), is a classified balance sheet. Interest receivable, inventory, prepaid insurance, and prepaid rent are included as current assets. Uptown considers these assets current because they will be converted into cash or used by the business within a relatively short period of time. Uptown deducts the amount of Allowance for Doubtful Accounts from the total of accounts, notes, and interest receivable because it estimates that only $54,800 of $57,800 will be collected in cash.

In the property, plant, and equipment section, Uptown deducts the Accumulated Depreciation—Equipment from the cost of the equipment. The difference represents the book or carrying value of the equipment.

The balance sheet shows property taxes payable as a current liability because it is an obligation that is payable within a year. The balance sheet also shows other short-term liabilities such as accounts payable.

The bonds payable, due in 2022, are long-term liabilities. As a result, the balance sheet shows the account in a separate section. (The company paid interest on the bonds on December 31.)

Because Uptown is a corporation, the capital section of the balance sheet, called the stockholders' equity section in the illustration, differs somewhat from the capital section for a proprietorship. Total stockholders' equity consists of the common stock, which is the original investment by stockholders, and the earnings retained in the business. For homework purposes, unless instructed otherwise, prepare an unclassified balance sheet.

Closing Entries

Uptown makes closing entries in its general journal as shown below.

SUMMARY OF LEARNING OBJECTIVES

Understand basic accounting terminology. Understanding the following eleven terms helps in understanding key accounting concepts: (1) Event. (2) Transaction. (3) Account. (4) Real and nominal accounts. (5) Ledger. (6) Journal. (7) Posting. (8) Trial balance. (9) Adjusting entries. (10) Financial statements. (11) Closing entries.

Explain double-entry rules. The left side of any account is the debit side; the right side is the credit side. All asset and expense accounts are increased on the left or debit side and decreased on the right or credit side. Conversely, all liability and revenue accounts are increased on the right or credit side and decreased on the left or debit side. Stockholders' equity accounts, Common Stock and Retained Earnings, are increased on the credit side. Dividends is increased on the debit side.

Identify steps in the accounting cycle. The basic steps in the accounting cycle are (1) identifying and measuring transactions and other events; (2) journalizing; (3) posting; (4) preparing an unadjusted trial balance; (5) making adjusting entries; (6) preparing an adjusted trial balance; (7) preparing financial statements; and (8) closing.

Record transactions in journals, post to ledger accounts, and prepare a trial balance. The simplest journal form chronologically lists transactions and events expressed in terms of debits and credits to particular accounts. The items entered in a general journal must be transferred (posted) to the general ledger. Companies should prepare an unadjusted trial balance at the end of a given period after they have recorded the entries in the journal and posted them to the ledger.

Explain the reasons for preparing adjusting entries and identify major types of adjusting entries. Adjustments achieve a proper recognition of revenues and expenses, so as to determine net income for the current period and to achieve an accurate statement of end-of-the-period balances in assets, liabilities, and owners' equity accounts. The major types of adjusting entries are deferrals (prepaid expenses and unearned revenues) and accruals (accrued revenues and accrued expenses).

Prepare financial statements from the adjusted trial balance. Companies can prepare financial statements directly from the adjusted trial balance. The income statement is prepared from the revenue and expense accounts. The statement of retained earnings is prepared from the retained earnings account, dividends, and net income (or net loss). The balance sheet is prepared from the asset, liability, and equity accounts.

Prepare closing entries. In the closing process, the company transfers all of the revenue and expense account balances (income statement items) to a clearing account called Income Summary, which is used only at the end of the fiscal year. Revenues and expenses are matched in the Income Summary account. The net result of this matching represents the net income or net loss for the period. That amount is then transferred to an owners' equity account (Retained Earnings for a corporation and capital accounts for proprietorships and partnerships).

Prepare financial statements for a merchandising company. The financial statements for a merchandiser differ from those for a service company, as a merchandiser must account for gross profit on sales. The accounting cycle, however, is performed the same.

 

APPENDIX   3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING

Most companies use accrual-basis accounting: They recognize revenue when the performance obligation is satisfied and expenses in the period incurred, without regard to the time of receipt or payment of cash.

Some small companies and the average individual taxpayer, however, use a strict or modified cash-basis approach. Under the strict cash basis, companies record revenue only when they receive cash. They record expenses only when they disperse cash. Determining income on the cash basis rests upon collecting revenue and paying expenses. The cash basis ignores two principles: the revenue recognition principle and the expense recognition principle. Consequently, cash-basis financial statements are not in conformity with GAAP.

An illustration will help clarify the differences between accrual-basis and cash-basis accounting. Assume that Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustrations 3A-1 and 3A-2 show the net incomes for each month under cash-basis accounting and accrual-basis accounting.

For the three months combined, total net income is the same under both cash-basis accounting and accrual-basis accounting. The difference is in the timing of revenues and expenses. The basis of accounting also affects the balance sheet. Illustrations 3A-3 and 3A-4 (page 120) show Quality Contractor's balance sheets at each month-end under the cash basis and the accrual basis.

Analysis of Quality's income statements and balance sheets shows the ways in which cash-basis accounting is inconsistent with basic accounting theory:

1. The cash basis understates revenues and assets from the construction and delivery of the garage in January. It ignores the $22,000 of accounts receivable, representing a near-term future cash inflow.
2. The cash basis understates expenses incurred with the construction of the garage and the liability outstanding at the end of January. It ignores the $18,000 of accounts payable, representing a near-term future cash outflow.
3. The cash basis understates owners' equity in January by not recognizing the revenues and the asset until February. It also overstates owners' equity in February by not recognizing the expenses and the liability until March.

In short, cash-basis accounting violates the accrual concept underlying financial reporting.

The modified cash basis is a mixture of the cash basis and the accrual basis. It is based on the strict cash basis but with modifications that have substantial support, such as capitalizing and depreciating plant assets or recording inventory. This method is often followed by professional services firms (doctors, lawyers, accountants, and consultants) and by retail, real estate, and agricultural operations.³

CONVERSION FROM CASH BASIS TO ACCRUAL BASIS

Not infrequently, companies want to convert a cash basis or a modified cash basis set of financial statements to the accrual basis for presentation to investors and creditors. To illustrate this conversion, assume that Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2014, Dr. Windsor received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 − $170,000). At January 1 and December 31, 2014, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in Illustration 3A-5.

Service Revenue Computation

To convert the amount of cash received from patients to service revenue on an accrual basis, we must consider changes in accounts receivable and unearned service revenue during the year. Accounts receivable at the beginning of the year represents revenues recognized last year that are collected this year. Ending accounts receivable indicates revenues recognized this year that are not yet collected. Therefore, to compute revenue on an accrual basis, we subtract beginning accounts receivable and add ending accounts receivable, as the formula in Illustration 3A-6 shows.

Similarly, beginning unearned service revenue represents cash received last year for revenues recognized this year. Ending unearned service revenue results from collections this year that will be recognized as revenue next year. Therefore, to compute revenue on an accrual basis, we add beginning unearned service revenue and subtract ending unearned service revenue, as the formula in Illustration 3A-7 shows.

Therefore, for Dr. Windsor's dental practice, to convert cash collected from customers to service revenue on an accrual basis, we would make the computations shown in Illustration 3A-8.

Operating Expense Computation

To convert cash paid for operating expenses during the year to operating expenses on an accrual basis, we must consider changes in prepaid expenses and accrued liabilities. First, we need to recognize as this year's expenses the amount of beginning prepaid expenses. (The cash payment for these occurred last year.) Therefore, to arrive at operating expense on an accrual basis, we add the beginning prepaid expenses balance to cash paid for operating expenses.

Conversely, ending prepaid expenses result from cash payments made this year for expenses to be reported next year. (Under the accrual basis, Dr. Windsor would have deferred recognizing these payments as expenses until a future period.) To convert these cash payments to operating expenses on an accrual basis, we deduct ending prepaid expenses from cash paid for expenses, as the formula in Illustration 3A-9 shows.

Similarly, beginning accrued liabilities result from expenses recognized last year that require cash payments this year. Ending accrued liabilities relate to expenses recognized this year that have not been paid. To arrive at expenses on an accrual basis, we deduct beginning accrued liabilities and add ending accrued liabilities to cash paid for expenses, as the formula in Illustration 3A-10 shows.

Therefore, for Dr. Windsor's dental practice, to convert cash paid for operating expenses to operating expenses on an accrual basis, we would make the computations shown in Illustration 3A-11.

This entire conversion can be completed in worksheet form, as shown in Illustration 3A-12.

Using this approach, we adjust collections and disbursements on a cash basis to revenue and expense on an accrual basis, to arrive at accrual net income. In any conversion from the cash basis to the accrual basis, depreciation or amortization is an additional expense in arriving at net income on an accrual basis.

THEORETICAL WEAKNESSES OF THE CASH BASIS

The cash basis reports exactly when cash is received and when cash is disbursed. To many people, that information represents something concrete. Isn't cash what it is all about? Does it make sense to invent something, design it, produce it, market and sell it, if you aren't going to get cash for it in the end? Many frequently say, “Cash is the real bottom line,” and also, “Cash is the oil that lubricates the economy.” If so, then what is the merit of accrual accounting?

Today's economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision-makers seek timely information about a company's future cash flows. Accrual-basis accounting provides this information by reporting the cash inflows and outflows associated with earnings activities as soon as these companies can estimate these cash flows with an acceptable degree of certainty. Receivables and payables are forecasters of future cash inflows and outflows. In other words, accrual-basis accounting aids in predicting future cash flows by reporting transactions and other events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3A

Differentiate the cash basis of accounting from the accrual basis of accounting. The cash basis of accounting records revenues when cash is received and expenses when cash is paid. The accrual basis recognizes revenue when the performance obligation is satisfied and expenses in the period incurred, without regard to the time of the receipt or payment of cash. Accrual-basis accounting is theoretically preferable because it provides information about future cash inflows and outflows associated with earnings activities as soon as companies can estimate these cash flows with an acceptable degree of certainty. Cash-basis accounting is not in conformity with GAAP.

 

APPENDIX   3B USING REVERSING ENTRIES

Use of reversing entries simplifies the recording of transactions in the next accounting period. The use of reversing entries, however, does not change the amounts reported in the financial statements for the previous period.

ILLUSTRATION OF REVERSING ENTRIES—ACCRUALS

A company most often uses reversing entries to reverse two types of adjusting entries: accrued revenues and accrued expenses. To illustrate the optional use of reversing entries for accrued expenses, we use the following transaction and adjustment data.

1. October 24 (initial salaries and wages entry): Paid $4,000 of salaries and wages incurred between October 10 and October 24.
2. October 31 (adjusting entry): Incurred salaries and wages between October 25 and October 31 of $1,200, to be paid in the November 8 payroll.
3. November 8 (subsequent salaries and wages entry): Paid salaries and wages of $2,500. Of this amount, $1,200 applied to accrued salaries and wages payable at October 31 and $1,300 to salaries and wages payable for November 1 through November 8.

Illustration 3B-1 shows the comparative entries.

The comparative entries show that the first three entries are the same whether or not the company uses reversing entries. The last two entries differ. The November 1 reversing entry eliminates the $1,200 balance in Salaries and Wages Payable, created by the October 31 adjusting entry. The reversing entry also creates a $1,200 credit balance in the Salaries and Wages Expense account. As you know, it is unusual for an expense account to have a credit balance. However, the balance is correct in this instance. Why? Because the company will debit the entire amount of the first salaries and wages payment in the new accounting period to Salaries and Wages Expense. This debit eliminates the credit balance. The resulting debit balance in the expense account will equal the salaries and wages expense incurred in the new accounting period ($1,300 in this example).

When a company makes reversing entries, it debits all cash payments of expenses to the related expense account. This means that on November 8 (and every payday), the company debits Salaries and Wages Expense for the amount paid without regard to the existence of any accrued salaries and wages payable. Repeating the same entry simplifies the recording process in an accounting system.

ILLUSTRATION OF REVERSING ENTRIES—DEFERRALS

Up to this point, we assumed the recording of all deferrals as prepaid expense or unearned revenue. In some cases, though, a company records deferrals directly in expense or revenue accounts. When this occurs, a company may also reverse deferrals.

To illustrate the use of reversing entries for prepaid expenses, we use the following transaction and adjustment data.

1. December 10 (initial entry): Purchased $20,000 of office supplies with cash.
2. December 31 (adjusting entry): Determined that $5,000 of office supplies are on hand.

Illustration 3B-2 (page 126) shows the comparative entries.

After the adjusting entry on December 31 (regardless of whether using reversing entries), the asset account Supplies shows a balance of $5,000, and Supplies Expense shows a balance of $15,000. If the company initially debits Supplies Expense when it purchases the supplies, it then makes a reversing entry to return to the expense account the cost of unconsumed supplies. The company then continues to debit Supplies Expense for additional purchases of supplies during the next period.

Deferrals are generally entered in real accounts (assets and liabilities), thus making reversing entries unnecessary. This approach is used because it is advantageous for items that a company needs to apportion over several periods (e.g., supplies and parts inventories). However, for other items that do not follow this regular pattern and that may or may not involve two or more periods, a company ordinarily enters them initially in revenue or expense accounts. The revenue and expense accounts may not require adjusting, and the company thus systematically closes them to Income Summary.

Using the nominal accounts adds consistency to the accounting system. It also makes the recording more efficient, particularly when a large number of such transactions occur during the year. For example, the bookkeeper knows to expense invoice items (except for capital asset acquisitions). He or she need not worry whether an item will result in a prepaid expense at the end of the period because the company will make adjustments at the end of the period.

SUMMARY OF REVERSING ENTRIES

We summarize guidelines for reversing entries as follows.

1. All accruals should be reversed.
2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed.
3. Adjusting entries for depreciation and bad debts are not reversed.

Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3B

Identify adjusting entries that may be reversed. Reversing entries are most often used to reverse two types of adjusting entries: accrued revenues and accrued expenses. Deferrals may also be reversed if the initial entry to record the transaction is made to an expense or revenue account.

 

APPENDIX   3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED

In this appendix, we provide an additional illustration of the end-of-period steps in the accounting cycle and illustrate the use of a worksheet in this process. Using a worksheet often facilitates the end-of-period (monthly, quarterly, or annually) accounting and reporting process. Use of a worksheet helps a company prepare the financial statements on a more timely basis. How? With a worksheet, a company need not wait until it journalizes and posts the adjusting and closing entries.

A company prepares a worksheet either on columnar paper or within a computer spreadsheet. In either form, a company uses the worksheet to adjust account balances and to prepare financial statements.

The worksheet does not replace the financial statements. Instead, it is an informal device for accumulating and sorting information needed for the financial statements. Completing the worksheet provides considerable assurance that a company properly handled all of the details related to the end-of-period accounting and statement preparation. The 10-column worksheet in Illustration 3C-1 (on page 128) provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet.

WORKSHEET COLUMNS

Trial Balance Columns

Uptown Cabinet Corp., shown in Illustration 3C-1 (page 128), obtains data for the trial balance from its ledger balances at December 31. The amount for Inventory, $40,000, is the year-end inventory amount, which results from the application of a perpetual inventory system.

Adjustments Columns

After Uptown enters all adjustment data on the worksheet, it establishes the equality of the adjustment columns. It then extends the balances in all accounts to the adjusted trial balance columns.

ADJUSTMENTS ENTERED ON THE WORKSHEET

Items (a) through (g) below serve as the basis for the adjusting entries made in the worksheet for Uptown shown in Illustration 3C-1.

The adjusting entries shown on the December 31, 2014, worksheet are as follows.

Uptown Cabinet transfers the adjusting entries to the Adjustments columns of the worksheet, often designating each by letter. The trial balance lists any new accounts resulting from the adjusting entries, as illustrated on the worksheet. (For example, see the accounts listed in rows 32 through 40 in Illustration 3C-1.) Uptown then totals and balances the Adjustments columns.

Adjusted Trial Balance

The adjusted trial balance shows the balance of all accounts after adjustment at the end of the accounting period. For example, Uptown adds the $2,000 shown opposite the Allowance for Doubtful Accounts in the Trial Balance Cr. column to the $1,000 in the Adjustments Cr. column. The company then extends the $3,000 total to the Adjusted Trial Balance Cr. column. Similarly, Uptown reduces the $900 debit opposite Prepaid Insurance by the $360 credit in the Adjustments column. The result, $540, is shown in the Adjusted Trial Balance Dr. column.

Income Statement and Balance Sheet Columns

Uptown extends all the debit items in the Adjusted Trial Balance columns into the Income Statement or Balance Sheet columns to the right. It similarly extends all the credit items.

The next step is to total the Income Statement columns. Uptown needs the amount of net income or loss for the period to balance the debit and credit columns. The net income of $12,200 is shown in the Income Statement Dr. column because revenues exceeded expenses by that amount.

Uptown then balances the Income Statement columns. The company also enters the net income of $12,200 in the Balance Sheet Cr. column as an increase in retained earnings.

PREPARING FINANCIAL STATEMENTS FROM A WORKSHEET

The worksheet provides the information needed for preparation of the financial statements without reference to the ledger or other records. In addition, the worksheet sorts that data into appropriate columns, which facilitates the preparation of the statements. The financial statements of Uptown Cabinet are shown in Chapter 3 (pages 115–116).

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3C

Prepare a 10-column worksheet. The 10-column worksheet provides columns for the first trial balance, adjustments, adjusted trial balance, income statement, and balance sheet. The worksheet does not replace the financial statements. Instead, it is an informal device for accumulating and sorting information needed for the financial statements.

Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.

Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS.

Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.